Jack in the Box Tries to Make It Work

Back at the beginning of October, Ryan Fusaro made his big move into the value investing world by calling out Jack in the Box (Nasdaq: JACK) at the Value Investing Conference. At the time, Jack in the Box was trading at $28, while Fusaro claimed it had a fair value closer to $39. So what is the company doing that's kept the stock price depressed, and what could it do to kick things up? More importantly, is there any reason to jump in with Jack in the Box now, or are investors better off waiting for a bigger turnaround?

The argument for Jack in the BoxTo summarize the work that Fusaro presented -- which you can read about in-depth in my previous article on the subject -- let's look at the three main points in his argument. First, he claims that Jack in the Box is no longer the business it once was. The rest of the case for Jack in the Box hinges on the idea that the market has yet to understand the transformation that the company has undertaken. The main portion of that transformation is its move from company-owned stores to franchises. The newer franchise model generates a steady stream of income, yet it requires less risk for the company.

On top of that transformation, Jack in the Box has also aggressively expanded the Qdoba brand. Qdoba is a Chipotle (NYSE: CMG) and Yum! Brands' (NYSE: YUM) Taco Bell rival, serving fast, custom-made burritos. Fusaro thinks the company will eventually be able to spin off or sell Qdoba, generating additional income in the future.

The final important point for investors is the main thing that keeps Jack in the Box from taking off: costs. The company has suffered with general and administrative costs, and margins have fallen. Fusaro points to Burger King (NYSE: BKW) as a sort of model. The King operates four and a half times as many locations as Jack in the Box, but it spends only about 65% more on administration. If Jack in the Box can right-size its backroom costs, it can generate all kinds of additional income.

The hurdle of the fourth quarterIf investors are going to buy into the Jack in the Box system, the company needs to keep growing its top line, increase the number of franchises, and expand its margins through effective cost-cutting. That's not the easiest set of things to work on, but clearly the cost-cutting has to take precedence. Even if you ignore the upsides that Fusaro called out, costs need to come down at Jack in the Box if the company wants to make more money.

Costs went up. SG&A accounted for 15.2% of revenue this quarter, and only 14.6% in the quarter last year. That means that Jack in the Box failed to do what it really needed to do. The company's release said costs increased because of "higher incentive compensation accruals, increased G&A related to Qdoba growth, and higher pension and pre-opening costs, which were partially offset by lower advertising and overhead costs resulting from the company's refranchising strategy." The only acceptable increase in there is the costs associated with Qdoba growth. The rest of it could have been managed or offset.

But sales are up, the company is still moving toward getting more income from franchisees, and adjusted earnings per share rose. Those are all good things, and things that make Jack in the Box a tempting stock. But costs have to come down. It's not a good thing for them to come down, and it's not a bonus if they come down -- it is necessary that they come down. Right now, the company is generating less income for shareholders because it can't get its act together on costs. That's not a company to invest in.

The bottom lineWhen Fusaro made his pitch, Jack in the Box was trading at around $28 per share. Today, it's just above $26. The company is floundering and just cannot seem to hold on to the money it's bringing in. Maybe it needs to take a step back from expansion and get its house in order before it pushes forward. That would be a sensible approach to growth, and it would help the company in the long haul. But it doesn't look like that's in the cards.

For fiscal 2013, Jack in the Box is forecasting the percentage of revenue spent on SG&A to fall less than half of one percentage point. That's not good enough for investors. If you like what Jack in the Box is doing, I would hold out. There is almost no reason to buy this company now, and with no movement in costs, I can't see the stock going up substantially from its current position. The only hope for a bump would come from the sale or spinoff of Qdoba.

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